Sunday, March 25, 2012

In testimony before the PCAOB roundtable on auditor independence, former SEC Chair Harvey Pitt said that mandatory audit firm rotation is one way to achieve auditor independence, but another way is to require company audit committees to regularly review the outside auditor’s performance under PCAOB standards with an eye towards not retaining an auditor that fails to meet the standards. It would be unfortunate, he said, if mandatory audit firm rotation deprives the audit committee of exercising real judgment.

Audit committees would have to develop a systemic methodology to assess the performance of the outside auditor and the circumstances under which a firm must be discharged. As part of this methodology, he noted, the audit committee would need generic information beyond its individual circumstances that only the SEC and PCAOB can provide. While the audit committee of a public company has knowledge of only its own auditor as it relates to the company, the PCAOB sees audit firms in multiple context.

The former SEC Chair urged the Board to find a way, with SEC assistance and there may need to be legislation, for the generic data to be communicated to the audit committee. The Board could communicate generic descriptions and statistical analyses, as well as the factors that are causing the Board concern. Armed with this data, audit committees could be requited at set an interval, Mr. Pitt suggested every five years, to make an affirmative finding that the company’s outside auditor exceeds whatever standards the Board articulates. The Board could spell out the conditions under which an outside auditor could remain in that role.

Mr. Pitt believes that requiring audit committees formally to consider whether, and then to explain and document the reasons that they have determined, to retain their outside auditors can be an effective short-term method of addressing auditor independence and the quality of audits, but only if two conditions precedent are satisfied. First, the Board should articulate the general standards it wishes to see audit committees apply, and second, the Board and the SEC should share information with audit committees in the possession of both bodies that could prove important to audit committees in making an independent judgment whether to retain the company’s outside auditors.

Former SEC Chair Arthur Levitt said that investors deserve the perspectives of different audit professionals every so often, especially when an auditor’s independence can be reasonably called into question. The former SEC Chair detailed three situations arguing for mandating auditor rotation: 1) if the audit firm has been employed by the client for a significant period of time, such as 10 years; 2) if one or more former partners or managers from the audit firm now work for the client; 3) if the audit firm performs significant non-audit services, even if approved by the audit committee.

The major criticism of auditor rotation mandates is the damage to institutional memory among the audit teams. But former SEC Chairman Levitt noted that most of the billable work of an audit is done by front-line staff who themselves rotate from audit firm to audit firm. Noting that the only continuity is among the partners and managers who oversee the work, the former Chair said the concern about lost institutional memory is misplaced.